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Even small dividends can generate big returns if you give them time to grow.

The Forecasts has consistently advised readers not to buy the highest-yielding stocks. They tend to be more volatile than the average stock yet do not provide any excess return. But please don’t interpret our stand on high-yielders as a dig against all dividends. We love stocks that pay dividends, as long as the companies can comfortably afford and are committed to increasing the payout.

For an illustration of the benefits of dividend growth, check out the chart below. The S&P 500 Index’s dividend yield has averaged about 2.2% since 1991. From 1991 through October 2008, the index rose 193%. But had dividends been reinvested annually, the index would have returned 323%.

Two factors accounted for that growth:

• The power of compounding. The total return modeled below assumes the dividend was reinvested in the index at the end of each year, boosting the amount of the index owned. That boost in turn magnifies the effect of both capital gains and dividend payments on future portfolio value.

• Rising payout. During the period modeled, which covers nearly 18 years, the S&P 500’s dividend grew at an annualized rate of 4.8%.

Historically, a stock’s dividend yield has not been a particularly effective tool for identifying whether that stock will outperform. A portfolio consisting of the top one-fifth of S&P 500 stocks as measured by dividend yield roughly matched the return of the average stock.

Of the income-related statistics used for the Quadrix® stock-rating system, payout ratio was most effective, with the top one-fifth of the S&P 500 averaging 12-month returns of 14.2% since 1990 — higher than the average stock but well below the 16.9% return of top Quadrix Overall scorers. Payout ratio reflects the percentage of earnings paid out as dividends, with low percentages earning high scores.

While the Forecasts considers capital gains and income return of equal value (to us, a 10% gain and 0% yield is of the same value as a 6% gain and a 4% yield), we acknowledge that many subscribers are concerned about income.

Three of those stocks are reviewed in the following paragraphs:

Exxon Mobil($78; NYSE: XOM) distributes a quarterly dividend of $0.40, with the next payment slated for Dec. 10. The annual payout represents just 18% of trailing earnings, allowing Exxon plenty of flexibility to spend on capital projects, buy back shares, and raise the dividend. The payout has increased in each of the last 26 years. At the end of September, Exxon held $38.43 billion in cash and equivalents, or about $7.45 per share, versus $7.38 billion in long-term debt.

In the 12 months ended September, operating cash flow increased 22% and free cash flow climbed 26%. Exxon spent nearly $27 billion on share repurchases in the nine months ended September and is likely to continue boosting the payout and aggressively buying back stock. The company also plans capital expenditures of $25 billion to $35 billion in each of the next five years.

A diversified business mix limits Exxon’s exposure to falling oil prices. In the September quarter, upstream operations (energy exploration and production) generated 70% of profits, while 22% came from downstream (refining crude oil into gasoline, heating oil, and other products) and the rest from chemicals. While upstream profits tend to follow the path of oil and gas prices, downstream and chemical operations can benefit from low prices for their petroleum inputs. Continued low oil prices should reduce the refining segment’s costs and improve profit margins. Exxon Mobil is a Long-Term Buy.

Sigma-Aldrich($40; NASDAQ: SIAL) has raised its dividend every year since initiating the payout in 1992. The stock yields 1.3%, and investors should receive their next quarterly payment of $0.13 per share on Dec. 15. Cash flow and free cash flow fell in the September quarter, though both rose at least 20% in the 12 months ended September. Wall Street expects per-share-profit growth of 13% in 2008 and 5% in 2009. At 14 times expected 2009 earnings, Sigma-Aldrich looks reasonably valued.

About 70% of sales come from the health-care industry, generally a strong market even during economic downturns. Sigma-Aldrich sells chemicals and kits to drug and biotechnology labs, customers that usually continue to work on long-term projects regardless of economic conditions. The company expects customers to cut back on expansion projects and equipment purchases before curtailing spending on research. For this reason, Sigma-Aldrich considers itself recession-resistant — as does the Forecasts.

For new sales opportunities, the company looks abroad. Sigma-Aldrich has aggressively expanded in China since 2006 and could experience accelerating growth there over the next three to five years. Sigma-Aldrich is a Long-Term Buy.

Walgreen($24; NYSE: WAG) has a long, solid history of dividend growth, raising the dividend for 33 consecutive years. Walgreen yields 1.9% and pays out just 21% of earnings in dividends. Operating cash flow grew by double digits in each of the past four fiscal years, with a 41% increase in fiscal 2008 ended August. Per-share-profit growth of 7% in fiscal 2008 represented the first annual gain of less than 10% since 1993.

While the drugstore business is fairly defensive, Walgreen should see profit growth accelerate as economic conditions improve, boosting sales of traditional retail products. Prescription drugs account for roughly two-thirds of company sales, affording Walgreen substantial insulation from economic conditions. Sales and per-share profits have risen in each of the last 19 years, a trend likely to continue in the years ahead. An innovator in the drugstore industry, Walgreen has set the standard for the modern pharmacy, with a drive-through window and 24-hour operations.

After years of aggressive expansion, Walgreen is slowing store growth to focus on boosting sales and profitability at existing stores, a move that should save the company $500 million in capital expenditures over the next three years.

Walgreen stores tend to reach peak profitability five or six years after opening. With 36% of stores less than five years old, the slowdown in expansion should cause same-store sales to increase over the next several years, reversing a trend seen in recent months. In November, sales rose just 4%, hurt by a 0.9% decrease in same-store sales. Walgreen, trading at just 11 times expected year-ahead earnings, is a Long-Term Buy.

DIVERSIFIED DIVIDEND PORTFOLIO

Annual. Div.
—– Growth —–

———— Quadrix Scores * ————

Company (Price; Ticker)

Div.
($)

Yield
(%)

Payout
Ratio
(%)

3 Yrs.
(%)

10 Yrs.
(%0

Value

Quality

Fin'l
Str.

Overall

Sector

Advice

Accenture ($30; ACN)

0.50

1.7

19

19

NM

60

96

94

94

Technology

Focus
Buy †

Aflac ($43; AFL)

1.12

2.6

38

31

23

53

68

84

76

Financials

LT Buy

Airgas ($32; ARG)

0.64

2.0

21

35

NM

65

88

48

89

Materials

Focus
Buy

AstraZeneca ($37; AZN)

1.90

5.1

41

10

9

66

93

75

93

Health Care

Buy †

Chevron ($76; CVX)

2.60

3.4

23

10

8

73

92

89

97

Energy

Buy †

Exxon Mobil ($78; XOM)

1.60

2.1

18

9

7

64

92

84

94

Energy

LT Buy

General Dynamics($50; GD)

1.40

2.8

24

18

12

74

83

72

94

Industrials

Buy †

Harris ($33; HRS)

0.80

2.4

22

32

5

74

92

64

96

Technology

Focus
Buy †

IBM ($80; IBM)

2.00

2.5

24

26

16

62

89

69

89

Technology

Focus
Buy †

Johnson & Johnson($57; JNJ)

1.84

3.2

41

9

13

38

83

92

84

Health Care

Focus
Buy †

Lockheed Martin($74; LMT)

2.28

3.1

30

24

10

59

89

61

80

Industrials

LT Buy

Microsoft ($19; MSFT)

0.52

2.7

23

14

NM

62

90

95

88

Technology

Buy †

PepsiCo ($54; PEP)

1.70

3.1

48

15

12

29

85

91

70

Consumer Staples

Buy †

Qualcomm ($31; QCOM)

0.64

2.1

34

15

NM

28

94

99

65

Technology

Focus
Buy †

Schlumberger ($44; SLB)

0.84

1.9

18

22

8

61

96

91

92

Energy

LT Buy

Sigma-Aldrich ($40; SIAL)

0.52

1.3

20

8

14

27

84

86

73

Materials

LT Buy

United Technologies ($46; UTX)

1.54

3.3

31

17

15

65

83

59

88

Industrials

Buy †

Walgreen ($24; WAG)

0.45

1.9

21

20

13

66

79

81

79

Consumer Staples

LT Buy

* Quadrix scores are percentile ranks, with 100 the best. † Also qualifies as a Long-Term Buy. NM Not meaningful.

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